SBIA Capital Formation Agenda

SMALL BUSINESS INVESTOR ALLIANCE:

Capital Formation AgendaLegislative Recommendations for Members of the 114th Congress

DEAR MEMBER OF CONGRESS,

We believe public policies that help small businesses gain access to capital is

crucial to our nation’s economic growth and job creation, and access to growth

capital should be at the forefront of the Agenda.

The Small Business Investor Alliance (SBIA), the nation’s premier organization

for lower middle market investors, submits to you the SBIA: Capital Formation

Agenda; Legislative Recommendations for Members of the 114th Congress,

a public policy guide designed specifically for Congress. These legislative

recommendations, when enacted into law, will provide the essential means to

increasing capital access for small businesses.

Please take a look at this guide to learn more about how small business

investors are making a difference in the capital formation process. Additionally,

we hope you can support our legislative agenda by sponsoring and voting yes for

these initiatives on the House or Senate floor.

Please let us know if you have any specific questions about this agenda. Our

legislative team welcomes the opportunity to meet with you or your staff at

your convenience.

I look forward to working with you to promote capital formation for our nation’s

small businesses.

Sincerely,

Brett Palmer

President

Small Business Investor Alliance

Capital Formation AgendaLegislative Recommendations for Members of the 114th Congress

SMALL BUSINESS INVESTOR ALLIANCE:

ABOUT THE SMALL BUSINESS INVESTOR ALLIANCE

The Small Business Investor Alliance (SBIA) is the premier organization of lower middle

market private equity (PE) funds and investors. SBIA members provide vital capital to

growing small and medium sized businesses nationwide, resulting in job creation and

economic growth.

SBIA member funds employ various investment strategies including growth equity,

mezzanine, debt, buyout, and venture capital. SBIA member funds invest long-term

capital in domestic small businesses in nearly every state across the country.

Most members of SBIA are structured as private equity partnerships, pooling capital

from limited partners to invest in companies nationwide. A primer on private equity

can be found on page 20. About half of the SBIA member funds are licensed as Small

Business Investment Companies (SBIC). SBICs are U.S. Small Business Administration

(SBA)-regulated investment vehicles that can borrow up to two times the private capital

they raise to invest in small businesses. See page 23 for more background on the

SBIC Program.

A growing number of SBIA members are structured as Business Development Companies

(BDCs), which are SEC-regulated investment vehicles that raise money from retail

investors through private and public offerings. See page 26 for a primer on BDCs.

The SBIA membership also consists of institutional limited partner investors in these

funds. These limited partner (“LP”) investors are banks, family offices, funds of funds,

and insurance companies.

SBIA is the leading advocate in Washington, D.C., representing private equity funds,

BDCs, and SBICs. SBIA has been serving a pivotal role in promoting the growth and

vitality of the lower middle market for more than 50 years.

iv SBIA: Capital Formation Agenda

SBIA: Capital Formation Agenda v

TABLE OF CONTENTS

About the Small Business Investor Alliance iv

Private Equity and Job Creation 1

SBIA Portfolio Company of the Year 3

SBIA Capital Formation Legislative Agenda

SBIC Family of Funds Legislation 4

BDC Modernization Legislation 7

SEC Investment Adviser Relief 10

Eliminate SBIC Double Regulation 11

SEC Office of Small Business Advocate 13

SBIC Program Modernization 14

Don’t Pass Punitive Tax Increases 15

Qualified Small Business Investment Tax Incentive 17

Attract Foreign Capital in BDCs 19

What is Private Equity? 20

What is an SBIC? 23

What is a BDC? 26

SBIA Government Relations Team 28

SBIA DC Fly-In 28

SBIA Champion of Small Business Investing Award 29

vi SBIA: Capital Formation Agenda

SBIA Members primarily invest

their capital in “lower middle

market” businesses, which are

small businesses that generate

between $10 and $100 million

in revenues per year.

SBIA: Capital Formation Agenda 1

Private equity and job creation

WHY ARE SMALLER PRIVATE EQUITY FUNDS SO IMPORTANT TO CREATING VALUE AND ADDING JOBS?

According to a 2012 Pepperdine University study, private equity-backed establishments generated 129

percent more revenue growth and 257 percent more employment growth than their non-private equity-

backed counterparts.1

SBIA Members primarily invest their capital in “lower middle market” businesses, which are small

businesses that generate between $10 and $100 million in revenues per year. Middle market companies

account for ¹/³ of private U.S. employment, or 45 million jobs. According to research by the National Center

for the Middle Market, middle market companies have recently been the strongest sector of the economy

in terms of revenue and employment growth, with annual revenue growth of 6.6 percent and annual

employment growth of 3.2 percent in 2014.2

Revenue Growth (Lower Middle Market Businesses vs. S&P 500 Companies)

0%

2%

4%

6%

8%

10%

Source: National Center for the Middle Market

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 4Q15E

Lower Middle MarketS&P 500

Revenue growth for lower middle market companies has been significantly more stable and higher than for

S&P 500 firms. Entering 2015, smaller companies were expected to continue growing revenues at about

a six percent rate which is higher than expectations for S&P 500 companies.

1 Paglia, John and Maretno Harjoto. “Did They Build That? The Role of Private Equity and Venture Capital in Small and Medium Sized Businesses.” Graziado School of Business and Management, Pepperdine University, http://bschool.pepperdine.edu/newsroom/wp-content/uploads/2012/12/Paglia-Harjoto-PE-VC-11.29.2012-IEGC.pdf

2 http://www.middlemarketcenter.org/performance-data-on-the-middle-market?ind=2q-2014-middle-market-indicator

2 SBIA: Capital Formation Agenda

Employment Growth (Lower Middle Market Businesses vs. Large Corp. (ADP))

1%

2%

3%

4%

5%

6%

Source: National Center for the Middle Market

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 4Q15E

Lower Middle MarketLarge Corporation

Employment growth at lower middle market businesses was in line with large businesses for most of 2013,

before taking a sharp upward turn in the first half of 2014. Employment prospects for smaller businesses

entering 2015 continue to be robust with projections greater than four percent.


SBIA Portfolio Company of the Year

The SBIA Portfolio Company of the Year Award recognizes the effectiveness of private equity financing and

the benefits of the partnership between private investors and small businesses. This competitive award is

given annually by the SBIA to the small business that demonstrates consistent strong growth characteristics

and robust financial performance while also providing increased employment opportunities in the local

markets in which it operates.

SBIA’s Portfolio Company of the Year Award has been presented to 35 outstanding SBIA-member portfolio

companies since 1987. Previous award winners have included such well-known companies as Intel, Callaway

Golf, and Build-A-Bear Workshop.

Green Compass, a portfolio company of SBIA member C3 Capital, won the prestigious 2014 SBIA Portfolio

Company of the Year. Green Compass is a leading provider of waste water treatment solutions. Through the

partnership, C3 Capital and Green Compass expanded waste water treatment services to new markets and

created jobs in those areas.

Located in Oxnard, California, Green Compass has treatment

facilities in Kern County, Orange County, and Ventura

County, which includes a 12.6 mile pipeline connection to

the municipal water treatment facility in Santa Paula. The

company was founded in 1959 with six employees and has

grown to over 120 employees across its four California

locations. In 2014, the company processed approximately

100 million gallons of waste water.LEFT TO RIGHT: Chris Roden, C3 Capital; Mike Blackburn, Petra Capital Partners (2015 SBIA BOG Chair); Robert Smith, C3 Capital; SBA Administrator Maria Contreras-Sweet; Doug Edwards, Chairman, Green Compass Environmental Solutions; Charles McCusker, Patriot Capital (2014 SBIA BOG Chair); Patrick Healy, C3 Capital; Brett Palmer; Charles Mundy, Green Compass Environmental Solutions; Gary Edwards, Green Compass Environmental Solutions


SBIA Capital Formation Legislative Agenda

SBIA Recommendation:

Increase SBIC Family of Funds Statutory Limitation

The Small Business Investment Company (SBIC) Program was signed into law in 1958 by President Dwight

Eisenhower to stimulate the flow of long-term patient capital to domestic small businesses. Today, there

are over 240 licensed SBICs across the country with over $22 billion in total assets. In Fiscal Year 2014,

SBICs invested more than $5.2 billion in new capital to small businesses nationwide. Since 2009, SBIC

investments have provided critical capital to small businesses, and this growth capital has increased 33

percent per year.

BACKGROUND OF THE SBIC FAMILY OF FUNDS LEGISLATION

The SBIC “Family of Funds” limit is a statutory cap that is currently restricting proven small business

investors from accessing new SBIC leverage. As many as 40 SBIC “Family of Funds” investors—which are

SBICs under the same management umbrella—are hitting the cap or will hit the cap if they raise their next

fund. If Congress increases this cap, SBIA estimates that SBICs will facilitate up to $750 million a year in

new small business investing.

According to the Congressional Budget Office, increasing the family of funds limit would not increase federal

spending. The provision has broad bipartisan support in both the House and Senate. SBIA recommends

raising the family of funds cap from $225 million to $350 million.

LEGISLATIVE HISTORY OF THE SBIC FAMILY OF FUNDS LEGISLATION

Congressman Steve Chabot (R-OH), the current Chair of the House Small Business Committee, introduced

legislation in the 112th and 113th Congress (H.R. 6504 and H.R. 1106, respectively) to increase the

SBIC family of funds limit from $225 to $350 million. The House of Representatives passed H.R. 6504

by an overwhelmingly bipartisan 359-36 vote on December 18, 2012. Senator Jim Risch and Senator

Mary Landrieu introduced the Senate version of the bill during the 113th Congress (S. 550 and S. 511,

respectively). S. 511 passed unanimously out of the Senate Small Business Committee on September 10,

2013.


Hawaii $11M

California$2.39B

Nevada $82M

Oregon $141M

Washington $218M

Idaho $16M

Montana $5M

Utah $256M

Arizona$261M New Mexico

$24M

Colorado $545M

North Dakota $13M

South Dakota $47M

Texas $1.6B

Oklahoma $95M

Kansas $104M

Nebraska $33M

Minnesota $399M

Iowa $69M

Wisconsin $250M

Missouri $285M

Arkansas$28M

Illinois $807M

Puerto Rico $19M

Michigan $329M

Indiana $152M

Kentucky $105M

West Virginia $22M

Tennessee $351M

Mississippi $29M

Louisiana $187M

Alabama$141M

Ohio $389M

Florida $1.04B

Georgia $641M

Virginia $316M

North Carolina $661M

South Carolina $183M

Pennsylvania $707M

New York $1.6B

Vermont $72M

Maine $29M

New Hampshire

$61M

Massachusetts $865M

Rhode Island $77M

Connecticut $341M

New Jersey $717M

Delaware $25M

Maryland $185M

District of Columbia

$21M

Total Small Business Investment Companies Investments by State (FY 2010-2014)


“It’s important for my colleagues to know that this bill does not cost the

taxpayers’ money, nor does it increase the risk of the program. The SBIC

debenture program will remain a zero subsidy program. That means that

the SBICs that participate must pay an up-front fee to cover any losses. It’s

good public policy like this that truly helps business grow and access capital

at no cost to taxpayers.”

Rep. Steve Chabot (R-OH), Dec. 18, 2012

“Over the past five years, SBICs have invested over $13.5 billion in small

businesses nationwide. This simple bipartisan fix will enable SBICs to invest

billions more in capital to small businesses in the next few years alone.”

Steve Hobman, NewSpring Capital, an SBIC based in Philadelphia, PA

Steve Hobman, General Partner, NewSpring Capital, an SBIC based in Philadelphia, PA

According to the Congressional Budget Office, increasing the

family of funds limit would not increase federal spending.



Modernize Business Development Companies for the 21st Century

Business development companies (“BDCs”) were created in 1980 by Congress to spur investment in small

and mid-sized businesses. Today, this industry is growing rapidly and providing capital to small and mid-

size businesses across the country, filling gaps that have been vacated by traditional lenders. BDCs allow

retail investors an opportunity to invest in small and mid-size companies by purchasing shares of publicly-

traded BDCs.

Modernizing the regulations that impact BDCs will unleash more capital for job creation and business

growth and help the industry mature to reach its full potential. SBIA is the only collective voice for BDCs

on Capitol Hill and is committed to encouraging capital formation and realizing Congress’ intent when they

created BDCs in 1980.

BACKGROUND OF BDC LEGISLATION

The Modernization of BDC regulations will allow BDCs to deploy more capital; they are currently limited to a

1:1 debt-to-equity ratio as opposed to banks and other financial vehicles that are often leveraged at a 9:1

ratio or higher. Allowing a modest increase in the leverage for BDCs will enable them to deploy significantly

more capital to small and mid-size businesses, while simultaneously reducing the risk in their portfolios,

Publicly Traded BDC Asset Growth (as of June 30, 2014)

Source: Jonathan Bock, BDC Analyst, Wells Fargo Securities

4,712.6 4,980.2 5,091.4 5,456.5 5,329.9 5,674.7 6,161.3 6,698.1 6,919.6 8,726.5 10,260.2 10,893.212,192.713,016.7 14,378.4 15,865.6 17,403.6 19,205.6 20,888.5 22,770.4 25,337.0 30,285.6 29,955.2 31,090.6 30,460.3 31,711.3 30,151.9 24,831.6 23,950.2 23,279.0 23,341.7 24,425.8 22,669.1 23,949.9 24,215.2 26,081.2 28,678.4 30,166.5 30,774.7 32,366.2 34,898.5 37,384.1 40,546.6 45,125.1 47,597.5 51,841.4 55,879.0 60,522.5 64,808.0 68,800.2 73,110.0

“1Q02”2Q02“3Q02”4Q02“1Q03”2Q03“3Q03”4Q03“1Q04”2Q04“3Q04”4Q04“1Q05”2Q05“3Q05”4Q05“1Q06”2Q06“3Q06”4Q06“1Q07”2Q07“3Q07”4Q07“1Q08”2Q08“3Q08”4Q08“1Q09”2Q09“3Q09”4Q09“1Q10”2Q10“3Q10”4Q10“1Q11”2Q11“3Q11”4Q11“1Q12”2Q12“3Q12”4Q12“1Q13”2Q13“3Q13”4Q13“1Q14”2Q14“3Q14

0

10

20

30

40

50

60

70

80

2014201320122011201020092008200720062005200420032002

$ in

Bill

ions


as they can invest in lower yielding, lower risk investments and still generate valuable returns to their

shareholders. The modernization legislation also includes provisions to streamline the offering, filing, and

registration processes for BDCs at the Securities and Exchange Commission (SEC), eliminating significant

regulatory burdens.

THE BDC INDUSTRY—PROVIDING CRITICAL CAPITAL

Currently, there are over 70 BDCs in existence and the sector is growing rapidly. Total outstanding

loan balances by the BDC industry to small and medium businesses has grown from $10 billion in

2007 to over $65 billion during the fourth quarter of 2014.

LEGISLATIVE HISTORY OF BDC MODERNIZATION LEGISLATION

BDC Modernization legislation was introduced in the 113th Congress (H.R. 1800). The House advanced the

bill, passing it out of the House Financial Services Committee on November 14, 2013. No further action was

taken in the 113th Congress.

“H.R. 1800…will increase the ability of Business Development Companies

to lend to small businesses and help ensure the flow of capital to

Main Street.”

—Jeb Hensarling, Chairman, House Financial Services Committee, November 14, 2013.

Modernizing the

regulations that impact

BDCs will unleash more

capital for job creation

and business growth...


“The Investment Company Act of 1940 places very significant operational

restrictions on BDC’s including severely limiting the ability to deploy

leverage, restrictions on ownership of registered investment advisers,

prohibitions and limitations on many types of joint and affiliated

transactions, and requiring extensive public disclosure on everything from

its portfolio investments to its financing arrangements.”

—Curtis Hartman, Chief Credit Officer, Main Street Capital, a BDC in Houston, Texas.

“BDCs can fill a larger void for small business capital if Congress

modernizes the current BDC regulatory structure. BDCs are currently being

held back on their ability to grow their capital structure, with restrictions

placed on leverage levels and preferred stock. BDCs are also left at a

disadvantage when they offer their securities on market exchanges and

in their compliance and reporting responsibilities with the Securities and

Exchange Commission (SEC).”

—Tom Aronson, Managing Director, Monroe Capital, a BDC in Chicago, Illinois

“While the BDC industry continues to grow, I strongly believe that we can

expand our scope and do more to fulfill our policy mandate. To that end, I

am here today on behalf of the BDC industry to express support for current

proposed legislation that seeks to make straightforward, prudent changes

to the Investment Company Act of 1940 in order to enable BDCs to more

easily raise and deploy capital to small and medium size businesses.

It is important to note that BDCs are not seeking any government or

taxpayer support or subsidy. The BDC industry is simply asking Congress to

modernize their regulatory framework so that BDCs can more easily fulfill

their Congressional mandate.”

—Michael Arougheti, CEO, Ares Capital Corporation, Testimony before the House Subcommittee on Capital Markets & GSEs, October 23, 2013.



Provide Regulatory Relief for Small Business Investors

Under the 2010 Dodd-Frank Act, the regulatory landscape for private equity funds changed dramatically.

The changes require most private equity funds to register with the SEC as investment advisers, and smaller

private equity advisers to register or report to the SEC or their state securities regulator. SEC registration

is expensive and, in most cases, the investment adviser rules are not designed for private equity funds. For

example, the initial cost to register with the SEC is often in excess of $100,000. Annual costs to comply

with SEC Investment Adviser rules are often $250,000 or more per year. Additionally, most SEC investment

adviser regulations are designed to protect retail investors and are more applicable to publicly traded

companies, not for small business investing.

SBIA supports exempting small business investors from the Investment Advisers Act. The $150 million

threshold that triggers SEC registration is too low and, at a minimum, the threshold should be raised.

Additionally, Congress should work expeditiously to clarify the exemption threshold for SBICs and streamline

the rules for smaller PE funds.

Small business investors commonly have very few employees, sometimes as few as two. Small business

investment funds generally do not have legal departments, compliance teams, or extra employees to

dedicate to adhering to a complicated regulatory regime not designed for their type of investing. Adding

additional overhead expenses for regulatory compliance teams and services severely restricts the ability of

small business investment funds to operate profitably.

The Complex Case of Dodd-Frank: Different Rules for Different Private Equity Funds

Dodd-Frank created an “Assets Under Management” (AUM) test to determine how most advisers of Private

Equity Funds are regulated. Other types of fund advisers are specifically exempt from registration, such

as Venture Capital (VC) Funds and Small Business Investment Companies, but only if they “solely” advise

those funds.

Size or Type of Fund Test Regulatory Regime

Fund advisers that advise PE Funds with more than $150 Million in AUM

Register with the SEC as Investment Adviser

Fund advisers that advise PE Funds with between $100-150 Million in AUM

Regulated by the SEC as “Exempt Reporting Adviser”; i.e., no registration, no examinations, but some paperwork and reporting

Fund advisers that advise PE Funds with less than $90-100 Million in AUM

Register with the state securities regulator, depending on state law

Fund advisers that “solely” advise VC funds

Regulated by the SEC as “Exempt Reporting Adviser”; i.e., no registration, no examinations, but some paperwork and reporting

Advisers that “solely” advise SBIC Funds SBICs are already Regulated by the SBA. Therefore, Congress exempted these funds from SEC Registration but, depending on state law, may have to register with the state regulator.

Advisers that advise SBIC Funds and VC Funds

SBICs and VC Funds Lose their Exemption and Must Register if AUM is greater than $150 Million. This Results in Double Regulation by SEC and SBA for SBIC Funds.

Advisers that advise SBIC Funds and PE Funds

The SEC Counts the SBIC AUM in the SEC Registration threshold, triggering automatic registration if above $150 Million in AUM. This Results in Double Regulation by the SEC and SBA for SBIC Funds.



Eliminate Double Regulation for SBICs

SBIA supports clarifying and streamlining this duplicative regulatory regime for advisers who manage both

SBICs and other types of VC or PE Funds. Legislation is needed to:

1. Eliminate duplicative registration of advisers solely to SBICs, removing the potential of two

regulators at the state and federal level.

2. Allow venture capital advisers to retain their exemption in Dodd-Frank if they choose to also advise

an SBIC fund.

3. Assist advisers that manage both traditional private equity funds and SBICs by exempting the SBIC

capital already regulated by the SBA from the SEC registration calculation.

LEGISLATIVE HISTORY OF SEC INVESTMENT ADVISER RELIEF LEGISLATION

When creating this provision in Dodd-Frank, it was clear that double regulation was to be avoided, but that is

not the way it has been applied.

Congressman Blaine Luetkemeyer (R-MO) introduced the SBIC Advisers Relief Act (H.R. 432) on January

21, 2015. H.R. 432 clarifies the Investment Advisers Act for certain advisers of SBICs. During the 113th

Congress a similar version of the bill (H.R. 4200) passed the House Financial Services Committee 56-0 on

May 22 and unanimously passed the House of Representatives on December 2.

In the 113th Congress, Congressman Robert Hurt (R-VA) and Congressman Jim Himes (D-CT) introduced

H.R. 1105, the Small Business Capital Access and Job Preservation Act. The legislation removed SEC

registration for private equity firms while maintaining certain investor safeguards. This bill passed the House

of Representatives on December 4, 2013.


“If an adviser advises for SBICs and any other private funds and the total

assets under management exceed the $150 million registration threshold

(as it does for Ironwood Capital) the threshold for full registration is

triggered. The double counting of capital, even otherwise exempt capital,

causes double regulation for advisers that advise SBICs and any other

private funds (non-SBICs). Firms should not be required to count the SBIC

exemption as part of the $150 million threshold. Congress did not intend for

firms to face the threat of double regulation, and it is important to remove

the double regulation of SBICs and non-SBICs.”

—Marc Reich, President, Ironwood Capital, a private equity fund in Avon, Connecticut.

“SEC registration has added costs to Centerfield in the form of higher

compliance costs and fees. Incremental costs have been incurred for

services rendered by third party legal and compliance professionals to

ensure that our policies and procedures incorporate the various SEC

requirements, many of which are not applicable to private equity. Such

resources have also been used for SEC examination preparedness. The fees

charged by our external auditors have increased to meet the accounting

firm’s higher standards for SEC registrants. These out-of-pocket costs and

the time spent by our professionals on SEC registration and compliance

detract from our mission of empowering small businesses to grow.“

—Faraz Abbasi, Senior Partner, Centerfield Capital, a private equity fund in Indianapolis, Indiana.



Create a Stronger Voice at the SEC for Small Business Interests

The SEC is not designed or focused on small business capital formation. It needs an Office of the Small

Business Advocate focusing on capital formation. A new Office of the Small Business Advocate could

provide an independent voice on small business concerns, particularly ways in which the SEC can be helpful

in encouraging capital formation to help those businesses grow. Having this additional voice at the SEC

will provide much needed insight and contribute the views of small businesses, which currently do not

receive sufficient attention at the Commission. The Advocate should be directed to coordinate the SEC’s

Advisory Committee on Small & Emerging Companies and the Government-Business Forum, both incubators

of important ideas designed to help encourage smart improvements to the securities laws and develop

initiatives to facilitate capital formation in the real economy.

“I believe the SEC needs to create an Office of the Small Business Advocate,

reporting to the Commission. This office would be modeled on the Office

of the Investor Advocate created by the Dodd-Frank Act. There’s a natural

parallel here, in that our staff perennially faces difficulty in receiving views

from certain segments of the market that find it difficult and expensive

to participate in the normal notice and comment rulemaking process:

retail investors and small businesses. Having a single point of contact for

outreach for these underrepresented groups, who can then turn around

and advocate their views to the staff, is critical. Finally, just as the

Investor Advocate now runs the Investor Advisory Committee, the Small

Business Advocate could take charge of the SEC’s Advisory Committee on

Small and Emerging Companies and the Government-Business Forum, an

incredibly important group that does not have the profile it deserves at

the Commission.”

—Commissioner Daniel Gallagher, U.S. Securities & Exchange Commission, September 17, 2014



Improve SBIC Program Operations

In order to continue the strong success of the SBIC program, the program must constantly update its rules

and regulations. SBIA supports any legislative initiatives that will ensure more effective and efficient use

of SBA resources and taxpayer dollars, streamline the program to enable increased participation from the

private sector, and update the program to keep pace with technological changes.

SBIA recommends modernizing the SBA by requiring the SBA to accept electronic signatures and records on

behalf of program participants when certifying and transmitting documents. This common-sense approach

will result in significantly less physical paper at the SBA, faster turnaround times in the program for SBICs,

and an updated program for the 21st century.

Additionally, SBIA recommends requiring the SBA to fix its licensing process by streamlining licensing for

SBICs applying for a repeat license. This would apply to SBICs with a strong track record and the same

management team that are returning to the SBA to be licensed. Instead of forcing these successful SBICs

to go through a long re-licensing process, legislation could be adopted to streamline the re-licensing process

for proven funds. This would reduce the burden on the SBA’s resources in the program and speed up the

licensing of new funds; therefore, increasing the effectiveness of the program, while still securing the quality

of the funds being re-licensed. SBIA believes this approach would help eliminate uncertainty for funds

coming back for re-licensing, speed processing times for new funds, and eliminate the crunch of limited

resources at the SBA.

“There are a number of major technological and information systems challenges that make it very difficult for SBA staff to administer the SBIC program effectively. We encourage a meaningful review and improvement in both the technological tools and the policies around them. One of the major problems for SBIC funds is the inability of the SBA to accept documents electronically. The SBA still requires SBICs to send hard copies for most documentation requests. The email system at SBA is unable to send or receive many documents. It is common that critical documents are delayed or lost in the mail room. The SBA needs to be able to communicate electronically. Further, it has been over a decade since laws were changed to require the acceptance of digital signatures, but the SBA requires paper copies, often with multiple copies. The SBA needs to modernize its documentation collection process to allow SBICs to communicate and submit documents electronically.”

—Steven Brown, Managing Partner, Trinity Capital Investment, Testimony before the House Small Business Subcommittee on Investigations, Oversight & Regulations, July 25, 2013.



Don’t Pass Punitive Tax Increases on Small Business Investors

Private Equity investing involves the long-term investment of patient capital that

provides a return years after the initial investment is made. As a result of the

long-term nature of these investments, the returns from these investments are

treated as a long-term capital gain under the tax code, and are taxed at a lower

rate than regular income. This concept is known as “carried interest.” Through

this investing structure, the general partner (GP) is compensated through “carry”

only if the fund is successful, as investors must receive back the value of their

initial investment, as well as a certain specified profit percentage, before the GP

receives their return. In this manner, the general partners’ economic interests are

aligned with those of the capital investors.

A partner’s share of income is subject to the entrepreneurial risks of the

partnership’s business. Any change in carried interest would distort the economic

interests between the fund managers and the outside capital investors,

eliminating the alignment that has resulted in successful deals and better value

creation for domestic small businesses.

The carried interest is also typically subject to a “clawback” provision that

requires the PE firm to return distributions to the extent of any subsequent

losses in other investments of the fund. If the fund generates losses on some

investments, the GP shares in the downside because any profits from its carry

from successful investments are offset by the unsuccessful deals. If enough

deals in a fund do poorly, the GP could be left with no carry at all.

IF THE CARRIED INTEREST MODEL IS DESTROYED, SMALL BUSINESS INVESTORS WILL BE HURT MOST

Private equity funds hold portfolio company investments in a bucket of companies

and the size of the fund matters in determining these investments. Small

private equity funds do not have the capacity to invest in large businesses. The

scale of their funds allows a portfolio of $10 to $20 million investments in 20

businesses, not one $500 million investment in only one company.

For smaller funds, if the carried interest tax rate increases dramatically, it makes less sense economically

to be able to sustain a fund. The smaller the fund, the less it will be able to withstand an increase in the tax

rate for carried interest because smaller funds cannot survive solely on asset-based management fees. As a

result, there will be fewer smaller investment funds and therefore less capital available for small business.

How Does Carried Interest Work?

Private equity funds pool the capital

of investors and invest this capital

into venture and growth companies.

Managers of these funds typically

receive an annual management fee of

two percent of the fund’s committed

capital and eligibility for a 20 percent

share in the profits of the fund. The

20 percent profit sharing interest is

referred to as the “carried interest.”

In most cases, the carried interest is

not realized for fund managers until

the investors’ capital is paid back

with interest, which usually occurs

in the latter part of a fund’s ten-year

lifecycle. Because fund managers must

successfully surpass a minimum profit

target or “hurdle rate” (i.e., 8%), the

realization of “carried interest” is

generally not guaranteed.

Upon receipt of the carried interest,

the fund manager gains interest in the

fund and pays tax in the same manner

as other partners (investors) on their

distributive share of the fund’s taxable

income. The character of the income

included in the manager’s distributive

share is the same as the character of

the income recognized by the fund.


“…Some have characterized it as an unfair loophole that must be closed.

But from where I sit any policy that ensures that capital can flow freely to

businesses seeking to grow and create jobs is crucial. And that is why the

current tax treatment of carried interest—as a capital gain—is entirely

appropriate…Private equity funds buy and sell companies, which no one

disputes are capital assets. As a result the tax code makes clear that profits

realized from the sale of those assets should flow to the limited and general

partners of the fund and be taxed as capital gains.”

—Pam Hendrickson, the Chief Operating Officer of The Riverside Company, a private equity firm, and member of the Small Business Investor Alliance.



Encourage Investments in Small Business through the Tax Code

One way to encourage investors to make capital commitments to small businesses is to reduce the capital

gains rate for holding the investment over the long haul. While the capital gains rate can be as high as 23%

for the sale of most long-term assets, Congress has recently allowed taxpayers to exclude capital gains

income for investments in qualified small business stock.

Long-term capital investments allow businesses to spend on capital projects and job creation. Many venture

and growth companies need extra cash to stay competitive and broaden their products into new markets. As

investors seek new opportunities to help small businesses grow, it is imperative that Congress continues

promoting long-term investments in qualified small businesses. The 1202 capital gains exclusion is a

excellent way to continue to encourage risk taking and patient capital.

The qualified small business investment tax incentive has been tucked into the annual tax extenders’ bill for

the past few years. Making this provision permanent is very important to provide certainty for investors and

to encourage long-term investment and business formation.

Congress should modernize this tax provision to apply to an expanded universe of small business

investments. SBIA recommends making these small changes:

1. Modernize the definition of QSB to include all investments consistent with the definition of small

business under the Small Business Investment Act of 1958 (as amended). This would simplify

eligibility requirements, requiring less paperwork and administrative burdens. Also, it would allow

more growth-oriented small businesses to access capital.

2. Clarify that small business stock can include stock acquired upon the exercise of warrants. This

would reduce the initial cost of capital for small businesses by adding equity to a debt deal.

3. Allow investors that sell qualified small business stock held over three years to defer recognition of

capital gains by reinvesting the sale proceeds in new qualified stock within six months. This would

encourage repeat investors to invest in more than one small business.

4. Increase the gross asset test in the Qualified Small Business (QSB) definition from $50 million

to $75 million and index for inflation. This update of the definition will keep up with the growth of

the economy.


“As my company looks to find portfolio company investment opportunities,

the qualified small business investing incentive is particularly appealing

to us because it increases the probability this capital will go to eligible

small businesses. I’d like to see Congress take the next step and make this

provision permanent and expand its usefulness by applying it to warrants.

Small business investing certainly deserves this attention.”

—Gayle Hughes, Partner, Merion Investment Partners, a private equity fund in Radnor, Pennsylvania

…imperative that

Congress continues

promoting long-term

investments in qualified

small businesses.



Attract Foreign Capital in Business Development Companies (BDCs)

SBIA supports making permanent a tax provision that incentivizes and attracts foreign investment in

domestic business development companies (BDCs), which are an important source of capital for small and

medium size companies.

BACKGROUND OF BDCS:

BDCs are government-regulated investment companies that were created in 1980 by Congress to spur

investment in and allow a new source of capital for small and mid-sized businesses. BDCs allow retail

investors an opportunity to invest in a portfolio of private small and mid-sized companies by purchasing

shares in the BDCs. Most BDCs are publicly traded on national exchanges.

Today, the BDC industry is a $65 billion industry and growing rapidly. There are over 70 active BDCs in the

U.S., and the SBIA is the leading advocate for BDCs across the country. BDCs invest debt and equity capital

in “middle market” companies, which are mid-sized companies that are in the range of $10 million and $1

billion in gross receipts. The middle market loan industry is a part of the market not being met by traditional

lenders such as banks.

For tax purposes, BDCs are structured as Regulated Investment Companies (RICs), which are pass-through

taxable entities requiring BDCs to pass through at least 90 percent of their income to shareholders each year.

REASON FOR LEGISLATION:

Section 871 of the U.S. Tax Code inhibits foreign investment in BDCs by requiring 30 percent withholding

of any interest to be paid to foreign investors of RICs. Legislation is needed to reduce permanently these

taxes, thereby encouraging more foreign investment in BDCs.

Incentivizing foreign capital to invest in BDCs will allow more capital for American job creation and business

growth and help the industry mature to reach its full potential. Not only will this encourage foreign

investment, it will give BDCs the ability to rely on a more stable flow of investment from abroad, allowing

them to pursue more confidently and aggressively their interests without the uncertainty of losing such

investment due to a gap of withholding protection. Foreign investors will also be able to ensure that their

long term investment plans will not be inhibited by tax barriers.

Legislative History:

On December 31, 2014, the temporary one-year removal of withholding tax on dividend interest payments

to foreign investors expired. As such, non-resident aliens are once again subject to a 30% withholding tax,

which has the potential to stymie further foreign investment. Congressman Erik Paulsen (R-MN) previously

introduced legislation to make permanent the removal of these withholding taxes on foreign investors. This

bill, H.R. 4555, introduced on May 1, 2014, in the last session of Congress, was not enacted.


What is Private Equity?

Private Equity consists of funds and the investors in those funds that provide equity and/or debt capital

to privately-owned companies (not listed on a stock exchange), or complete a “buyout” transaction of a

publicly traded company, taking it private, and delisting its stock from the stock exchange. Under the federal

securities laws, only an “accredited” individual or an institutional investor may invest in a private equity fund.

Accredited investors are those investors that have over $200,000 in annual income or at least $1 million

in net worth, excluding their primary residence. The lifespan of a traditional private equity fund is 10

years. During that time, the capital of the investors in the fund is locked up and returned over time as the

investments are paid off. This illiquid structure affords businesses the time required to execute on their

long term strategic goals. Private equity funds vary widely, depending on their investment strategy and

the financing needs of their businesses. They provide patient and flexible capital, and often specialize

in financing and supporting businesses at various stages of growth and maturity, as well as in specific

industries and geographies.

Investors

Investment Adviser

Manufacturing Co. (Michigan)

(hiring 20 new employees, expanding their production plant to meet new demand for tractors)

Technology Co. (California)

(hiring 10 new employees, expanding sales of a cloud based platform to international markets)

Healthcare Co. (Texas)

(hiring 40 new employees, funding expansion into the southeast region and building new hospitals)

Transportation Co. (Pennsylvania)

(financing an acquisition of a bus manufacturer)

Investment Capital ($$)

Management Expertise

Investment Fund Private Equity/SBIC/Venture Capital

Investment Returns ($$)

Investing Debt (Loans) or Equity (Shares)


The typical private equity fund structure, which mirrors that of a venture capital or SBIC fund, has an

investment adviser (often regulated under the Investment Advisers Act by the SEC), and the fund is

comprised of the invested capital from the managers of the investment adviser and the outside investors.

The fund is generally structured as either a partnership or an LLC, and the fund’s assets and investments

are directed by the managers that work for the investment adviser.

Private equity invests for the long term. During market and financial crises, the patient capital of private

equity funds can help businesses survive a downturn or economic shock. Small private equity funds do not

simply provide capital to small businesses and sit on the sidelines and hope they grow. They are active

investors that create value in their investments.

Following the investment, private equity fund managers often work closely with a company’s management

team to help accelerate the company’s growth. Fund managers work to improve profitability by developing

better products and services, expanding the sales channels, and introducing the portfolio companies to new

supply chains. Additionally, fund managers work with the CFOs of its portfolio companies to improve financial

operations and IT systems, reduce costs, and streamline financial reporting processes.

Private Equity Middle Market Deal Flow by Year

$0

$50

$100

$150

$200

$250

$300

$350

$400

2014201320122011201020092008200720062005

Source: Pitchbook 2015 Annual U.S. PE Middle Market Report

Capital Invested ($ Billions)

$303 $385$325$268$261$90$174$362$271$189

Private Equity consists of funds and the investors in those funds that provide equity and/or debt capital to privately-owned companies…


Private equity activity is driven by investments in middle market companies, which are firms valued at $25

million to $1 billion. Since 2009, private equity has invested over $1.6 trillion dollars in thousands of

middle market companies.

VENTURE CAPITAL FUNDS

Venture Capital funds are a type of private equity fund focusing investments on early-stage companies,

often providing equity or debt financing to startups and small and mid-size firms that have strong growth

potential. Venture financing is attractive to new companies that are too small to raise capital in the

public market and not credit worthy enough to attain a bank loan or issue debt themselves.


What is an SBIC?

Small Business Investment Companies (SBIC) have a long history of success helping small businesses

access long-term, patient capital for growth. For over 50 years, SBICs have been providing capital for

American small businesses and the jobs they create. The SBIC program, administered by the SBA, utilizes

the talent of experienced private investment fund managers to achieve critical public policy objectives. Fund

management teams that meet the SBA’s minimum requirements and successfully complete the application

process are able to access leverage up to two times the private capital they raise. These funds then invest

in a portfolio of U.S. small businesses, creating jobs, fostering innovation, and fueling economic growth.

HOW DO SBICS WORK?

x2

Private Investors

Small Business Investment Company

Small Businesses = Jobs

Private InvestorsFor the SBIC Program, private investors are critical partners to the U.S. Small Business Administration, supplying necessary capital to be matched by leverage. Private investors include: banks, pension funds, institutional investors, and high net worth individuals.

Small Business Administration (SBA)The SBA has overseen the SBIC program since its inception in 1958. SBICs pay an annual charge to the SBA to keep leverage at zero subsidy, with no cost to the taxpayer.

Small Business Investment Company (SBIC)SBICs are managed by highly qualified private equity professionals who have extensive experience investing in small businesses. Each SBIC fund manager meets or exceeds the stringent requirements set by the SBA, including proven investment track record and history of working together as a team.

U.S. Small BusinessesThe SBIC program goes a long way to solve the capital constraints of U.S. small businesses. Small businesses use this critical capital to expand facilities, buy equipment, and increase their workforce.

SBIC Leverage

Jobs


SBIC Debenture Program Total Capital by Fiscal Year

$0

$5

$10

$15

$20

20142013201220112010200920082007200620052004

Source: Small Business Administration

Capital under management ($ Billions)

$13.34

$15.90

$18.86

$11.07

$9.10

$7.60$6.90

$6.10$5.40$4.90$4.90

Distribution of SBIC Financing Dollars by Industry Reported FY 2009-2013 Total SIBC Financings = $13.5 Billion

Other

Wholesale Trade

Health Care and Social Assistance

Transportation and Warehousing

Information

Professional, Scienti�c, and Technical Services

Manufacturing

26%

7%

7%12%

14%

26%

8%


Distribution of SBIC Financing Dollars by Geography Reported FY 2009-2013 Total SIBC Financings = $13.5 Billion

East North Central11.4%

West South Central11.0%

West North Central5.2%

Mountain7.5%

Pacific7.5%

Middle Atlantic19.0%

South Atlantic17.8%East South Central

3.6%

New England8.9%


What is a BDC?

Business development companies (BDCs) were created as a result of amendments to the Investment

Company Act of 1940 (’40 Act), passed as part of the Small Business Investment Incentive Act of 1980.

BDCs are designed to provide loans and management expertise to middle-market businesses. BDCs are

structured as a pass-through entity for tax purposes (Registered Investment Company or RIC), register and

sell shares in public offerings under the SEC rules, and trade on national exchanges (although not all BDCs

are currently traded on a national exchange). As BDCs are registered and public funds, retail investors

are eligible to invest in them. BDCs receive the yield of illiquid private equity funds, generally without the

illiquidity risk.

Retail InvestorsPublic Equity Capital Markets

Investment Company Act of 1940

Small and Middle-Market Businesses

Business Development Companies

Accredited Investors

Private Equity Firms

Investment Return

Investment Return

Investment Dollars

Investment Dollars

BDCs are designed to provide loans

and management expertise to small

and middle-market businesses.


There are currently over 70 BDCs in existence in the U.S. with over $65 billion in assets. Traditional lenders,

such as banks, are facing increased regulatory burdens and unable to invest in BDCs. The BDC percentage

of leveraged loans is seen as likely to grow significantly. BDCs, including the amount of capital raised, have

grown significantly. The following illustrates the types of investments that BDCs make.

Senior Term Loan

§ Secured by 1st lien behind the bank revolver

§ 2nd in the capital stack

§ Repaid after Senior Revolver

§ Traditional banks provide “Senior Revolver loans”

Unitranche Loans

§ Secured by 1st lien behind the bank revolver

§ Repaid after Senior Revolver

§ Blended combination of senior/subordinated into one loan with blended interest rate

Second Lien

§ Secured by 2nd lien behind the bank’s senior debt portion

Subordinated Debt

§ Secured/unsecured debt

§ If secured, it is paid after all Senior debt is repaid (including Second Liens)

Preferred/Common Stock

§ Equity

§ Total loss if company fails, lower value than preferred stock

§ High risk/higher return

Traditional Banks BDCs Private Equity/Mezzanine Funds

Source: Jonathan Bock, BDC Analyst, Wells Fargo Securities


SBIA Government Relations Team

SBIA’s Government Relations Team welcomes the opportunity to talk with you about the impact of private

equity investment in your state or district. We have a database of thousands of small businesses across

the country that have received financing from our member funds. We are eager to work with you to make

progress on the SBIA Legislative and Regulatory Agenda.

Brett PalmerPresident

Chris WaltersSenior Director, Governmental and Regulatory Affairs

Chris HayesLegislative and Regulatory Counsel

SBIA DC Fly-In

Every year, SBIA holds an annual DC Fly-In with the goal of updating Members of Congress and their staff on

the SBIA Legislative and Regulatory Agenda. If an SBIA member is in attendance from your Congressional

district, the SBIA Government Relations team will set up a meeting with your office.

Left to right: Charles McCusker partner at Patriot Capital in Baltimore, MD (2014 SBIA Board Chair); SBIA President Brett Palmer; Mike Painter, Partner at Plexus Capital in Raleigh, NC; U.S. Senator Jim Risch; Mike Blackburn, Partner at Petra Capital Partners in Nashville, TN (2015 SBIA Board Chair); Joe Alala, Chairman and CEO of Capitala Investment Advisers, Charlotte, NC; Chris Hayes, SBIA Legislative and Regulatory Counsel


SBIA Champion of Small Business Investing Award

During the Congressional session, the Small Business Investor Alliance hands out Champion of Small

Business Investing Awards to Members of Congress in recognition of their commitment to championing

small business investing policies. Several Members of Congress received this award in the 113th Congress

including Congressman Blaine Luetkemeyer (R-MO), Congresswoman Carolyn Maloney (D-NY), Congressman

David Cicilline (D-RI), Congressman Steve Chabot (R-OH), and Senator Jim Risch (R-ID).

Photos by Blanken Photography

SBIA President Brett Palmer, J.D. White, partner at Founder’s Equity in New York, and Joe Burkhart at Saratoga Investment Company in New York, presented the SBIA Champion of Small Business Investing Award to Rep. Carolyn Maloney (D-NY)

Holly Huels, Senior Vice President, Capital for Business in St. Louis, Missouri, presents Congressman Blaine Luetkemeyer (R-MO) the SBIA Champion of Small Business Investing Award

Barry Peterson, partner at Northcreek Mezzanine in Cincinnati, OH, presents Congressman Steve Chabot (R-OH) the SBIA Champion of Small Business Investing Award

1100 H Street, N.W.

Suite 1200

Washington, D.C. 20005

(202) 628-5055

www.SBIA.org

Documents

SBIA Capital Formation Agenda